Salvaging a deteriorating economy

The G-Sec market saw a steep rise in yield of about 100 basis points (a basis point is 0.01 per cent). This is the steepest upward movement in yield in a single month since 2000. We will try to understand the behavior pattern of the data that guides interest rates, yield and bond prices.

Over the past three months, several central banks have cut the policy rates in an effort to try and salvage a deteriorating economy. The Reserve Bank of India, too, has followed suit in initiating action by cutting the rates aggressively. The turn of events since January has ensured that the market is not too enthused by the rate reduction.

The fiscal deficit for 2008-09 was projected to be 3% at the time of budget presentation in February 2008 and is now is expected to cross the 6%. A combination of lower than expected revenues, higher expenditure due to fiscal stimulus, farm loan waiver and pay commission to name a few have led to this situation.

Add the oil, fertilizer and food subsidies, the fiscal deficit may well cross 7.6%. If you take into account, deficits of the State Government, the consolidated deficit is likely to exceed 11%. This has led to the Central Government net borrowing going up to Rs 2.24 lakh crore, with the gross borrowing going up to Rs 2.69 lakh crore. This is as compared to the Rs 1 lakh crore and Rs 1.6 lakh crore estimated at the time of the budget.

The incremental issuance of government securities due to higher borrowing requirement started in November. Such a significant supply without a corresponding demand has pushed yields of such securities higher at every auction. This is in spite of the fact that Open Market Operations were conducted by RBI at regular intervals to enable market participants to unwind their securities to create space for the fresh supply.

Further, when the Government presented an interim Budget for 2009-10 the fiscal deficit estimated was 5.5% of the next year GDP. The resulted in estimated gross borrowing of around Rs 3.6 lakh crore and net borrowing of around Rs 3 lakh crore next year. The market lacks clarity on whether such a huge supply can be adsorbed well by matching demand. It is quite obvious that any negative gap in demand is likely to push the yields higher.

A borrowing calendar for the first six months has been announced recently for a total amount of Rs 2.4 lakh crore. This is almost two-third of the total gross borrowing announced. This front loading is partly because of the redemption of dated and MSS securities coming up for redemption in the first three months. The market suspects that RBI is creating space for further issuances, if needed by the government, in the second half.

This can effectively push the fiscal deficit, borrowing program and issuance of securities for the whole year to much higher level than envisaged. The uncertainty on this front is keeping the market players on tenterhook preventing them from creating any serious demand on the government securities. RBI has announced buyback of securities to the extent of Rs 80,000 crore through open market operations for the same period in an effort to ease the situation.

Over the past couple of months, we have seen that the present conduct of open market operations through bidding process has not resulted in the keeping yields soft. This can also be attributed to the fact that the commercial banks were using the RBI window to book profits for FY 2009.

Going forward, we do not expect equal amount of selling of securities to the RBI through open market operations. This can push the yield lower and lead to RBI indicating a yield curve which the market will find it difficult to ignore. The quantum of RBI buying of securities through open market operations over the past few weeks almost matched what was issued afresh through auctions This has resulted in SLR going down, which may result in pent up demand in Government securities from commercial banks.

Over the last few months, the RBI has been racing against time regarding completion of borrowing program leaving less room for cancellation of auctions. RBI/Government is also looking at the possibility of private placement of central government securities with the RBI to lessen the burden on the market. Last but not the least with such a huge fiscal deficit looming large RBI can justify an increase in SLR of commercial banks which can create significant incremental demand. We cannot forget that when we had such deficits in the past the SLR ratio was quite high.